But before deciding which options to trade, you must understand what they’re and how they function.
So let’s dive right in.
What Are Options?
Generally, they’re contracts issuing the bearers the right, but not obligations, to sell or purchase a certain amount of assets at a predetermined value or before it expires. Like other financial assets, options can be traded using a brokerage investment account. Most brokers have reliable options trading platforms.
These contracts are powerful as they can easily enhance your portfolio. They can do this by adding protection, income, and even leverage. So depending on your situation, there is always an options scenario for any investor’s goal. But knowing which options to trade can be challenging, especially for beginners.
What is option trading in share market? A great example is using options to hedge against a declining share market to limit your potential losses. Plus, these contracts are ideal for hedging purposes. Using options as hedging tools lowers the risk of losses at a reasonable cost.
How Options Work?
Options trading is basically determining the likelihood of future price events. This means that the higher the likelihood of the price increases, the more costly the option to profit will be. For example, the call value increases when the price of the underlying stock goes up.
Contracts with shorter duration are less valuable. And that’s because the likelihood of the price improving reduces as the expiry day gets closer. This means that a three months option is more valuable than a 1-month asset.
After all, it does have more time to improve. Another factor that can affect the option’s price is volatility. Volatility can create some huge price swings as it moves up or down. Therefore, volatility and options trading are linked in a certain way.
Options Types: Call and Put Options
Another crucial factor that you have to consider before deciding which options to trade is the types of options. Buying options contracts give you a right but not an obligation to purchase it when it expires.
A put option grants you a right to sell a financial asset, while a call options give you an obligation to purchase it. Call options grant you the right to purchase a financial asset before it expires or at the strike price.
A call option is like a deposit for a certain asset you can purchase later. Put options are the opposite of call options. For more call and put options examples, please read on.
Call Option Example
If you see a new building going up, you may want a right to buy it if certain requirements are met. In this scenario, you can benefit from the option of purchasing or not. After all, they can purchase the apartment in the next 2 years at about $500,000 or not.
Generally, the developer can’t grant this option for free, so they may require you to pay a premium. Therefore, you will pay a premium of $50,000. Once the project ends, you can pay the remainder. After finishing the house and confirming everything is ok, you will pay $500,000 even if the market value has doubled.
Put Option Example
You can insure your S&P index portfolio by purchasing a put option. If you suspect that a bear market may result in a loss in the future, then you can take a long position to safeguard 10% of your investment.
Therefore, if it’s trading at $5,000, then you can get a put option granting you the right to sell at $4,500 in 2 years. But if the price drops by 20% in 6 months, then you can only lose 10%.
If it doesn’t drop, then you may lose the premium spent. A put option is perfect insurance that can safeguard a huge percentage of your investment.
How to Trade Options?
Most brokers only grant access to options trading to qualified clients. Therefore, if you need access to options trading, then you should get approval for options and margins from the broker. Luckily, they have an options trading simulator that you can use to perfect your skills.
After getting approved, you can do the following:
- Sell puts
- Buy puts
- Sell calls
- Buy calls
Purchasing stocks grants you long positions while buying calls gives you potential long positions in underlying assets. Short selling a financial asset gives you short positions while selling calls gives you potential short positions.
Buying put options grants you potential short positions of your stock. Selling naked put options gives you a potential long position. Knowing these 4 scenarios can serve as a great start to options trading.
Folks who sell options are writers, and those buying options are holders. Put holders and call holders are not obligated to sell or purchase. Therefore, they have a choice to practice their rights or not.
Put writers and call writers are obligated to sell or buy when the financial asset expires in cash. This means that the sellers are more exposed in certain cases. Therefore, the writer can lose more than the value of the asset’s premium.
Short-Term Options vs. Long-Term Options
Options are usually categorized by their exact duration. For instance, the long-term options’ duration exceeds a year, while short-term options expire within less than 12 months. The main risk component of holding a short-term option is the time duration.
The extrinsic and time value of short-term options expires thanks to the short-term duration rapidly, while the long-term option doesn’t decay rapidly. On the other hand, the leading component of holding it over a year is the use of leverage. This means that it can magnify losses.
Short-term options are the catalytic event of the stock’s price. Long-term options are proxies for holding a firm’s shares while eyeing the expiration date. The main similarity between the two is that they can be European or American-style options.
Generally, options can be separated by the expiration date falls. The weekly options expire on Fridays. The others expire at the end of the day and month. The ETF and index options also offer quarterly expiries.